Heterogeneous Beliefs, Speculation, and the Equity Premium

ABSTRACT

Agents with heterogeneous beliefs about fundamental growth do not share risks perfectly but instead speculate with each other
on the relative accuracy of their models' predictions. They face the risk that market prices move more in line with the trading
models of competing agents than with their own. Less risk‐averse agents speculate more aggressively and demand higher risk
premiums. My calibrated model generates countercyclical consumption volatility, earnings forecast dispersion, and cross‐sectional
consumption dispersion. With a risk aversion coefficient less than one, agents' speculation causes half the observed equity
premium and lowers the riskless rate by about 1%.